M

ore than tvvo-thirds of the $25 trillion of financial assets held in
the United States is managed on behalf of investors by financial
intermediaries, ranging from trusts, mutual funds, and mortgage pools to insurance companies, pension funds, and bal~ks. Since the
inception of financial markets in industrial economies, savers have
entrusted much of their wealth to intermediaries that, in turn, finance the
projects of investors. Because of their importance, governments have long
regulated the activities of these intermediaries to ensure sound financial
markets, a foundation of secure economic development. The form of this
regulation has changed often over the centuries as intermediaries and
financial markets have changed ~vith economic conditions and the
demands placed on them. Currently, regulators both here and abroad are
considering reforms that not only might foster more efficient domestic
financial markets but also might prepare the way for more equitable
global markets.
The current discussions, like those past, engage views of financial
markets that are often difficult to reconcile. Some, who believe that these
markets potentially are relatively efficient, advocate minimal interference.
Regulations that require more than the necessary disclosure of investments and risks might introduce burdens that exceed their benefits.
Others, who believe that the prominence of intermediaries reflects the
limits of savers’ information, advocate regulations to insure the safety
and soundness of intermediaries. At the very least, regulations may
diminish the force of "credit cycles" and the threat of widespread
insolvency among intermediaries.
The first section of this article considers the role of financial intermediaries within competitive financial markets ;vherein all investors
view the prospects for each asset much the same. In these circtunstances,
the prices of assets and the allocation of resources do not depend greatly
on the activities of intermediaries. Accordingly, the regulation of these
intermediaries does not diminish the risks that fully informed investors
M
Richard W. Kopcke
Vice President and Economist, Federal
Reserve Bank of Boston. Kathryn
Cosgrove provided valuable research
assistance.
are willing and able to assume. At worst, regulations
such as mispriced deposit insurance or various taxes,
which force intermediaries to price risk and returns
differently than other investors, would influence the
volume and form of intermediation, but they ~vould
little disturb the uniform pricing of assets and risks.
The second section reconsiders the role of financial intermediaries when not all investors are fully
informed about the prospective returns on all assets.
In this case, the activities of intermediaries can influence both the prices of assets and the volume of
investment. Intermediaries that enjoy the confidence
of savers foster more efficient financial markets by
acquiring and managing proprietary information
about assets that are not very familiar in public
markets. Intermediaries’ cost of funds rises with their
leverage, in these circumstances, and this cost rises
most slowly for those with the best reputations. If
savers’ confidence in intermediaries’ investments varies with business conditions, financial institutions may
be "fragile" and markets may be prone to occasional
"crunches."
The third section discusses the role of regulation
when not all investors are fully informed. When the
cost of funds for intermediaries depends on savers’
state of confidence, public policy can influence the risk
premiums embedded in credit market yields by designh~g capital requh’ements, accounting rules, and
liability insurance coverage in order to foster the
prudent valuation of assets and the efficient flow of
funds from savers to investors. Because the consequences of these regulations vary with economic conditions, the actions of regulators, like those of the
monetary authority, may need to adjust with circumstances, so that they shift returns and risks during
business cycles in ways that dampen, rather than
exaggerate, attendant credit cycles. This section considers regulations that: (1) link intermediaries’ requirements for capital to their investments in certain
risky assets, (2) value intermediaries’ assets according to prevailing prices of comparable assets, and
(3) require intermediaries to undertake remedies
promptly should their capital fall sufficiently to violate
theh" requirements. Although these policies may tend
to stabilize intermediaries, conserving the value of
their capital when markets for their assets are liquid,
these policies also can destabilize intermediaries and
increase the risks inherent in investment when markets for theh" assets are illiquid.
The final section summarizes this article and
discusses the consequences of regulation for monetary
policy. At the very least, monetary policy must con38 November/December 1995
sider the potential influence of regulations on the
volume and timing of the flow of funds through
financial markets in order to best attain its macroeconomic goals. Yet, regulation that affects the terms on
which intermediaries are willing and able to make
investments over the business cycle is a kind of
monetary policy. If a common goal of both regulatory
The best regulation might be that
which, taking into accounL the
characteristics of financial
markets, transmitted the actions
of monetary policy with the fewest
distortions and "head winds."
and monetary policy is to promote safe and sound
financia! markets, then the best regulation might be
that which, taking into account the characteristics of
financial markets, transmitted the actions of monetary
policy ~vith the fewest distortions and "head winds"
through intermediaries to the decisions of savers and
investors. These regulations, like monetary policy,
might need to be sufficiently flexible to change with
economic conditions.
I. Homogeneous Opinions and the
Consequences of Regulation
Investors’ demands for assets depend on their
assessments of future returns on risky assets and their
tolerances for bearing the risks h~herent in these
assets. If everyone possesses the same information
about all assets and if everyone analyzes this information in similar ways, then all investors should assess
the potential returns on all assets much the same. With
this common understanding, all investors price the
risks in ever), asset the same in competitive financial
markets, despite any differences in their tolerances for
bearing those risks. Securities or portfolios with certainreturns are priced to yield the risk-free rate of
interest. The expected yields for other portfolios exceed the risk-free rate to the degree the uncertainty
in their returns cam~ot be reduced by diversification
or hedging, because investors expect to be paid the
market price for bearing risk (for example, Sharpe and
New England Economic Review
Alexander 1990). In these circumstances, savers and
investors are indifferent about each intermediary’s
assumption of risk.
Regulations and taxes can introduce frictions that
impede the uniform pricing of assets and of risks in
this ideal model. Not all regulations entail such distortions, however. Conventions that require complete
and timely financial statements from businesses and
intermediaries, for example, tend to foster the uniform
pricing of securities and risks. Furthermore, in the
absence of other frictions, regulations that set standards for capital or leverage do not disturb the uniform pricing of assets even though these regulations
may confine the investment strategies of financial
intermediaries. But, risks and returns will not be
priced uniformly when either investors or securities
are taxed differently or "deposit insurance" premiums
are not priced accurately. These differences, in conjunction with regulations fixing standards for the
capital and leverage of financial intermediaries, cause
financial intermediaries to value assets differently than
other investors do, thereby fostering fh~ancial innovations, such as the use of derivatives, which allow the
tradh~g of risks and returns in ways that avoid the
restrictions imposed by traditional regulations.
The Basic Role of Financial Intermediaries
Suppose that financial intermediation is frictionless, hampered by no special taxes, reserve requirements, proscriptions, or accounting inequities. If everyone is informed equally well about the potential
returns on fh~ancial assets, then all financial intermediaries in competitive markets are essentially mutual
funds that distinguish themselves by the additional
options and services they offer their customers. Banks
clear payments; insurers and pension plans write
contingent claims; many ~vrite commitments to provide funds to their customers; all guarantee the principal and a fixed rate of return on some of their
liabilities. Financial intermediaries also offer their customers investment services, not only by attending
to the details of purchases, sales, and maintaiuing
records but also by combh~ing customers’ funds so
that all may invest in diversified portfolios of assets.
The expected yields on liabilities issued by financial intermediaries (including the implicit value of the
services they offer their custo~ners) should match the
expected yields on portfolios of publicly traded securities bearing the same risk. Otherwise, customers
would "unbundle" their purchases of financial services, favoring "low-balance" arrangements with
November/December 1995
banks, insurers, and other intermediaries, in order to
earn more competitive returns.~ Traditional financial
intermediaries, in principle, can be regarded as portfolios of services, each of which might be subcontracted to the most efficient suppliers, as long as the
joint production of services yields negligible economies of scope (valuable externalities that vendors
otherwise would be unable to capture).
Accounting conventions that dictate the way intermediaries report either their income or the value of
their assets and liabilities, by themselves, alter neither
the performance of investments nor the way fully
If everyone is informed equally
well about the potential returns
on financial assets, then all
financial, intermediaries in
competitive markets are
essentially mutual funds.
informed, like-minded investors assess these investments h~ competitive markets. Similarly, regulations
that prevent financial intermediaries from holding
particular assets or from issuing particular liabilities
impose no significant tax on intermediaries. Consider
an extreme restriction that requires a loan company to
invest in only one type of asset, residential fixed-rate
mortgages, for example. The expected returns on these
mortgages compensate investors for the systematic
risks inherent in these loans. To the loan company’s
shareholders, who are able to diversify their overall
personal portfolios adequately, the title to the assets of
the company is essentially as valuable as the mortgages themselves, and it is priced accordingly.
In the circumstances described above, financial
intermediaries are not compelled to broaden their
powers or engage in "financial innovations." Intermediaries might undertake these activities out of convenience, trading derivatives, for example, in order to fix
~ Intermediaries migh~ earn rents as a result of their efficiencies
in managing funds or in providing other business services. Vendors
increasingly are profiting from their comparative advantages by
selling these services piecemeal. For example, some banks manage
substantial custodial operations, some mutual funds and pension
plans purchase administrative or insurance underwriting services
for their pension, annuity, and employee benefit funds, and some
investment advisors sell their services to funds sold by others.
Nezt, England Economic Review 39
tile terms of future sales or reduce transactions costs
by using one transaction to replace many. But, intermediaries cannot reduce their price of bearing risk
through these strategies. Because the distribution of
returns incorporated in all derivative coutracts, which
includes all liabilities of finaucial intermediaries, is
defined by the distribution of returns on their underlying assets, fully informed iuvestors price the risks
inhereut in all these derivatives according to tile risks
inherent in tile underlying iuvestments.
Figure
Catfihll With amt
IA/ilhoul Limih’d Liability
Capital without Limited Liability
C
Co
Risk aud Leverage
When everyone assesses the potential returns on
each asset the same, the cost of funds for each financial
intermediary depends on the risks inherent in its
assets, not on the way it finances these assets. The
returns required by an intermediary’s shareholders
and creditors vary with its leverage, because the
division of these returns between shareholders and
creditors also shifts with leverage. Nonetheless, the
average cost of funds remaius constant, other things
equal, because those assuming more risk price it no
differently than those shedding the risk.
If the liability of shareholders were uot limited to
their investment ill an iutermediary’s stock or if intermediaries’ investments ill safe assets were at least
as great as their debt, then shareholders would bear all
of the risk inhereut in the intermediary’s assets. In
these cases, the value of the intermediary’s equity
would change dollar-for-dollar with any change in the
value of its assets (Figure la), while the value of the
claims of its creditors would not change. For example,
if the intermediary’s assets of Ao comprise liabilities to
creditors of L and capital of Co, then as circumstances
increase total assets to A1, the value of liabilities
remaius at L while capital increases to Cu and the
value of equity also increases h’om CO to C~. Should
the value of assets fall to A2, the capital of the
iutermediary and the value of its equity would fall to
C2. If L exceeds the value of assets, shareholders
would be obligated to pay creditors for this deficieucy,
L-A.
Becanse shareholders’ liability is limited to their
capital and intermediaries’ investments in risky assets
ordinarily exceed their capital, the previous example
understates the risk borne by creditors and overstates
that borne by shareholders. With the shield of limited
liability (Figure lb), shareholders’ capital rises with
the value of assets, but their position does not fall
below zero when the value of assets fails to exceed
creditors’ claims against the intermediary. In this last
40
November/December 1995
o
A2 [,., L
C2
Capital with Limited Liability
Co
0
A2
L
Ao
A1
,Xsse~s
Value of Liabilities with Limited
Liability for Shareholders
L-C2
case, creditors would bear the losses as the value of
their position falls with the value of the intermediary’s
assets (Figure lc).
Limited liability confers both benefits and costs
on shareholders. The benefit takes the form of a put
option. The cost of this option is the premium that
fully informed creditors require for accepting tile risk
entailed by this optiou. As the intermediary’s assets
approach L (Figure 2a), the value of this option to
shareholders rises; the value of limited liability rises
with the odds of insolvency. Accordingly, shareholdNew England Economic Review
Figure 2
Value qf Equily wilh Limih’d Liabilily
a.
Value of Equity
with Limiled L~
..A,2
Value
Equ~ly
Creditors’ Expecled
Losses
Value of Equity
w lh L m ted Liabi ity
Value of Equity with
Limited Liability minus
Creditors’ Expected Losses
Aasels
ers’ equity--the sum of their capital and the value of
their put option--exceeds zero, other things equal,
even when the intermediary has little or no capital. As
assets fall well below liabilities, the value of the shareholders’ put option approaches L - A, because the
failure of the intermediary essentially is a certainty.
November/December 1995
Because the premium creditors require for accepting this put option equals the expected value of
creditors’ potential losses dne to insolvency (Figure
2b), auy benefit redounding to shareholders as a result
of the shield of limited liability is offset exactly by the
premium required by fully informed, like-minded
creditors. The value of the shareholders’ put option at
A~ (the vertical line in Figure 2a) equals the expected
value of creditors’ losses (the corresponding vertical
line in 2b), and the value of the shareholders’ put
option at A2 equals the expected value of creditors’
losses in excess of L - A2 (the vertical line in 2b).
Accordingly, the value of equity, which is capital plus
the value of the shareholders’ put option less the
prelnitun the intermediary pays on behalf of creditors
to compensate them for their expected losses, is identical to the value of the proprietors’ stake in the
absence of limited liability (Figures 2c and la). Shareholders’ expected rate of return with the protection of
limited liability, therefore, is the same as it would be
without that protection. Similarly, the creditors’ expected rate of return is the same in both examples. The
weighted average of shareholders’ and creditors’ expected yields, consequently, remains equal to the
expected return on assets.
In all cases, the cost of fnnds for intermediaries
depends on investors’ assessments of the returns on
their assets, not their leverage. Investors essentially
can tailor the leverage of an intermediary’s investments to match their own tastes, but they cannot
reshape the fundamental risks and returns inherent in
the intermediary’s assets (Modigliani and Miller 1958;
Miller and Modigliani 1961). Although shareholders’
expected returns rise when their intermediaries assume more risk, these greater returns compensate
them no more generously than other investments.
Consequently, investors who wish to bear more risk
need not favor intermediaries that assume greater
leverage; instead, these investors themselves may sell
safe assets or borrow to purchase the shares of intermediaries in order to achieve the requisite risk. Likewise, investors who have relatively little taste for risk
may purchase both the intermediary’s debt and its
equity to achieve their goals.
Vohu~tary Standards for Capital
In the frictionless circumstances examined above,
the customers of financial intermediaries are iudifferent about each intermediary’s assumption of risk, but
bankruptcy costs encourage the shareholders and
managers of intermediaries to set minimum capital
New Et~gland Economic Review 41
requireruents for themselves. When the capital of
intermediaries becomes sufficiently low, the resolutiou
of claims against their assets entails costs that reduce
shareholders’ and creditors’ returns. Accordingly, intermediaries acting in the best interest of shareholders
would maintain sufficient capital to ensure that bankruptcies are rare. These voluutary capital requirements ordiuarily rise as intermediaries iuvest greater
shares of their assets in risk}, securities.
The cost of resolving claims when an il~termediary becomes insolvent reduces the uet returns from
the intermediary’s assets that can be divided between
shareholders and creditors. Some of these costs are
explicit, such as the fees of those who advise creditors
and shareholders and the expense of uegotiatino~
o
claims. Regulators, moreover, may seize the assets of
intermediaries that are nearly insolvent even though
their capital is not exhausted.2 Some costs are implicit,
such as the interruption of careers or the diminished
reputation of the owners and managers of insolvent
intermediaries.
Because the threat of insolvency entails costs that
are matched by no offsettiug benefits, intermediaries
would tend to manage their balance sheets to minimize the probability of insolvency. Inasmuch as fully
informed creditors do not bear the expected costs
arising from bankruptcies without receiving adequate
compensation, the total risk premium that intermediaries incur on their liabilities is the sum of the premium entailed by shareholders’ limited liability and
the premium entailed by bankrnptcy costs. The lower
is an intermediary’s capital, the greater are the probability of insolvency and the expected cost of insolvency (Figure 3a). If, for example, the value of an
intermediary’s assets is only A~, then the value of its
equity would equal its capital, C~, in the absence of
bankruptcy costs. But, in this illustration, expected
bankruptcy costs are sufficiently great that the market
value of the intermediary’s equity is negligible~the
premium for bankruptcy costs exhausts shareholders’
returns. When capital is C2, the market value of equity
also is nearly C2. Because both the probability of
2 This policy of early intervention prevents the owners of
intermediaries f,’om increasing the value of their equity by assuming more risk once their capital becomes very low. Shareholders will
not do so in this model principally because they may earn excess
returns with no risk by adding more capital, as explained below.
The assumption of more risk is most attractive when not all
investo,’s value the equity of the intermediary the same, as explained in section lII.
Proposals that would impose penalties if intermediaries’ losses
in their trading portfolios exceeded some previously established
"capital cushion" also would encourage intermediaries to set standards for their capital (Kupiec and O’Brien 1995).
42 N, wember/December 1995
Figure 3
Risk mtd Iht, Value q/: Equity
a.
el
b.
Value of
Equity
with More Risky
Assets
bankruptcy and expected bankruptcy costs become
negligible as capital increases, the premium for bankruptcy costs essentially becomes inconsequential, and
the shareholders’ expected rate of return is restored
to the return they would earn on other equally risk),
investments.
Bankruptcy costs, therefore, encourage intermediaries to set and maintain minimum requirements for
capital, requirements that increase with their investments in risky assets. In the previous illustration, if
losses depress the intermediary’s capital to Cu then
by investing C2 - C1 in the intermediary, shareholders
New Emghmd Economic Review
increase their wealth by C2. This additional invest"deposit insurance" equals the expected value of
ment promises a return exceeding that available on
creditors’ potential losses due to a collapse of the
other equally risky investments, an excess return
value of the intermediary’s assets--the premimn credequaling C~/(C2 - C~).~
itors would reqnire for the shareholders’ put option if
This voluntary capital requirement rises as inthere were no deposit insm’ance (Merton 1977; Sharpe
termediaries invest a greater share of their portfolios
1978; Buser, Chen, and Kane 1981; Kane 1995). This
in risk), assets. Suppose C2 represents the intermediobligation may be covered by intermediaries’ holding
ary’s minimum standard for capital for a specific mix more capital, a fund held by the agency guaranteeing
of risky and riskless assets in its portfolio~with
the liabilities, or an aunual fee paid to the guarantor.~
capital below C:, the value of its capital would be
Financial iutermediaries are indifferent among these
discounted too greatly in equity markets. Should the
arrangements as long as each institution’s expense in
intermediary then place a greater share of its investevery case corresponds to its creditors’ expected losses.~
ments into risky assets, it would increase both its
probability of insolvency and its expected bankrnptcy
costs at every value of C (Figure 3b). Accordingly, the
value of its capital at C2 would be discounted more
greatly in equity markets, thereby requiring the intermediary to hold more capital than C2 in order to
maintain a relatively competitive rate of retnrn for its
shareholders.
Regulations limiting financial intermediaries’ leverage and investments in risky assets do not affect the
risks borne by their shareholders and creditors in
competitive financial markets, because these regulations alter neither investors’ perceptions of the risks
and returns inherent in assets nor their ability to
Even if creditors could levy fair insurance premirealize these risks and returns. Should regulations set
ums
on their own, liability insurance can provide
capital requirements above intermediaries’ voluntary
several
economies to intermediaries and their customstandards, then those shareholders and creditors who
ers.
A
guarantor
can monitor intermediaries more
wish to bear more risk may do so either by assuming
economically
than
their many creditors. Moreover,
greater leverage themselves or by shifting their other
because
creditors
holding
long-term liabilities ordiassets toward risky investments. More specific capital
requirements that depend on intermediaries’ investments in particular assets also entail no significant
3 In competitive markets, shareholders who ilwest (C2 - C~)
expect to receive assets whose value is the same. Here, by investbnrdens. These requirements, other things equal, do
ing (C2 - C~), they increase the value of their equity by C2, or C~
not increase the intermediary’s cost of funds, and, in
more than offered by other investments.
this case too, shareholders could increase their owu
~ Insurance funds are an additional capital cushion for insured
intermediaries. The Federal Deposit Insurance Corporation mainleverage and alter the composition of their other intains such a fund, but the states’ guarantee covering policies issued
vestments, if they so desired, in order to assume more
by insurance companies is backed by a call against the capital and
risk than permitted by these capital requirements.
earnings of the insurance industry--the guaranty fund is invested
hzstzra~~ce progra,z~ shoHld ztot
competitive finmwial markets
u~zless the premiums for
insHrinf the liabilities of
infermediaries are mispriced.
Liability Ittsttl’altce attd the Regulation
of Capital and Assets
When the liabilities of intermediaries are insured,
creditors no longer require risk premiums from intermediaries; instead, intermediaries pay these premiums to agencies guaranteeing intermediaries’ debts.
These insurance programs should not disrupt the
efficient operation of competitive financial markets
unless the premiums for insuring the liabilities of
internaediaries are mispriced. A proper premium for
November/December 1995
in the capital of insurance companies. When the guarantor is a
public agency some of this capital can be provided by taxpayers:
Premiums that banks pay to the FDIC may be deducted from their
taxable income and calls against insurers often may be declared as
credits against state tax liabilities.
Although insurance rates for depository institutions nominally
vary with their supervisors° rating of their risks, the effective
premiums are set according to rules that might not be sufficiently
flexible to represent properly each institution’s expecied losses
(Spopg 1994, pp. 117-8).
" Intermediaries would be indifferent between holding more
capital and accumulating a reserve held by its guarantors, provided
each intermediary is credited with a competitive rate of return on its
reserve (much like the structure of a cash-value life insurance
policy). This is not the case for an undifferenHated fund, such as that
of the FDIC.
New England Economic Review 43
narily must insure themselves against all future risks
that au intermediary might assnme, issuing these
liabilities wonld be prohibitively expensive for those
intermediaries that have no intention of assuming
substantial risks in the future, nnless intermediaries
can insure this intention.~ Guarantors that levy flexible
insurance premiums over the dnration of long-term,
fixed-rate liabilities give intermediaries the opportunity to issue such liabilities at appropriate rates of
interest.
Liability insurance premiums need not be explicit. Guarautors may effectively exact a fair premium, for example, by holding a call option against
intermediaries’ assets (Kane ~986; Pennachi 1987):
When the value of au intermediary’s assets is sufficieutly low relative to its liabilities, the guarantor may
either impose formal agreements on its managemeut
or seize its assets. The implicit remuneration that
guarantors receive iu the form of this call option
compensates them for their liability insurauce. With
the prompt enforcement of standards for the capital of
intermediaries, guarantors would require no other
insurance premium, because they seldom would experience underwriting losses, provided markets for
intermediaries’ assets aud liabilities were efficient.
The mispricing of insurance for the value of
intermediaries’ liabilities essentially causes the price
of bearing risk for the intermediary to diverge from
the market price. If a guarantor were to assess premiums that were less than creditors’ expected losses, the
guarantor would artificially lower the price of bearing
risk to intermediaries and their shareholders. This
would be analogous to creditors’ charging au intermediary a premium insufficient to cover their losses
(Figure 2b). At a point such as A~, an insufficient
insurance premium would not alter the value of the
shareholders’ put option, but it would reduce the
amount shareholders effectively pay creditors for this
option. Iu this case, the intennediary’s shareholders
would earn a rent which increases the value of their
eqnity (Figure 4). This rent would be greatest when,
~ Even in this frictionless model, policies that require intermediaries to issue subordinated debt in order to establish a "capital
cushion" sufficient to guarantee the claims of more senior creditors
would impose too great a premium for this insurance. Intermediaries’ cost of hinds would rise as they finance more of their assets
with longer-term, fixed-rate debt.
Liability insurance is not essential for intermediaries to issue
longer-term liabilities. By issuing short-term liabilities and buying
a longer-term interest-rate swap, agreeing to pay fixed and receive
floatiug, an intermediary essentially can issue longer-term debt,
while granting creditors the ability to adjust the yields on the
intermediary’s liabilities as necessary to correspond to its risks.
44 November/December 1995
Value of Equity
with Fail Insurance Premiums
Value of Equity
with LQW Insurance Premiums
other things equal, capital is lowest for any given
iusurance premium (A] versus A2). Accordingly, the
line representing the value of equity would shift
upward (to a degree that diminishes with the magnitude of capital), and, when the insurance premium is
sufficiently low compared to bankruptcy costs, the
value of equity could exceed the value of the intennediary’s capital. To exploit this rent, intermediaries
would increase both their insured liabilities and their
holdings of risky assets per dollar of capital. If, for
example, the intermediary wished to maintain capital
of C3 (point A3) with fairly priced insurance, it might
reduce its capital to C2 (point A2) if premiums were
sufficiently cheap. Whereas low premiums encourage
the taking of risks, excessive insurance premiums
would discourage intermediaries from offering insured liabilities with yields as high as the risk-free rate
of interest, thereby rendering these accounts unattractive to investors.
Taxes interfere with the efficient operatiou of
financial markets by altering investors’ assessments of
the effective returns and risks available on various
investments. Wheu investors or assets are not taxed
the same, financial markets ordinarily fail to price
risks and returns uniformly. Some taxes, such as
New England Economic Review
corporate income [axes or reserve requirements, impose extraordinary expenses on certain financial intermediaries. Unless these expenses are mi[igated in
other ways, the net burden of tax liabilities favors
intermediaries organized as mutual funds over other
financial intermediaries. Shareholders of intermediaries with the greatest tax burdens withdraw their
equity from the holding of portfolios of assets in order
to emphasize, instead, the provision of financial services, including the origination of securities.
Taxes interfere with the efficient
operation of financial markets by
altering investors" assessments of
the effective returns and risks
available on various investments.
Financial intermediaries pay both explicit and
implicit taxes. The return to equity for intermediaries
is generally taxed as corporate income, except for the
returns to the equity in qualified mntnal funds. Other
taxes are less explicit; banks, for example, must invest
some of their assets in reserves on which they earn no
return, as dictated by reserve reqnirements against
checkable deposits. Compliance with regulation also
imposes "taxes" on intermediaries. These tax liabilities diminish an intermediary’s net return on assets,
which prevents it from offe,’ing competitive retnrns to
its shareholders, provided fully informed creditors
expect to receive a competitive rate of retnrn on the
intermediary’s liabilities and these creditors receive no
compensating benefits, such as lower personal income
taxes on the income they derive from these liabilities
(for example annuities, retirement accounts, or insurance policies). Rather than purchasing the shares of a
taxed intermediary, savers would earn greater returns
by purchasing a levered portfolio of assets matching
that of the intermediary, thereby avoiding the need to
pay the intermediary’s taxes. Accordingly, the burden
of these taxes tends to reduce the value of equity
of intermediaries (the value of equity in Figure 4, for
example, shifts down by an amount reflecting this tax
burden at each value for capital).
Unless the burdens of intermediaries’ taxes are
offset by other considerations, the weight of these
liabilities encourages banks, life insnrance companies,
and other intermediaries to recast their accounts as
Novembe~JDecember 1995
shares in mutual funds that also offer other financial
services. Bankers and insurers, for example, promote
contracts invested in accounts separate from their
general acconnt, wherein creditors essentially become
shareholders in mutnal funds offered by these companies. Without resorting to the strategy of offering their
customers mutual funds, intermediaries do derive
some relief from the burden of corporate income
taxation as a result of provisions in the personal
income tax laws. People who hold permanent insurance policies, individual retirement acconnts, and annuities generally pay no ctn’rent [axes on the income
that accrues on these investments, thereby relieving
intermediaries fi’om having to pay returns on these
accounts that fully match the returns on alternative
investments on which savers mnst pay current income
taxes. Even with this concession, however, an insurance company selling tax-deferred annuities against
its general account cannot offer its creditors and stockholders net returns matching those of a mutual fund
that offers the same products becanse, other things
equal, the insurance company’s general account, unlike the mutual fund, incnrs the added expense of a
corporate income tax liability.
H. Heterogeneous Opinions
When investors are not informed equally well,
o1", for other reasons, investors do not agree abont the
potential returns on assets, the activities of financial
intermediaries influence both the prices of assets and
the volume of investment (Gurley and Shaw 1955,
1956, 1960; Tobin 1963; Carosso 1970; Baskin 1988).
Financial intermediaries, in principle, foster efficient
financial markets by acquiring and managing proprietary information about assets that are not very familiar to other investors. But the ability of intermediaries
to cultivate and harvest the fruits of this knowledge
depends on the confidence that others invest in the
intermediaries themselves. An intermediary’s cost of
funds, in these circumstances, rises with its leverage,
and this cost rises most slowly for those with the best
reputations. Because confidence in intermediaries’
investments tends to vary with business conditions,
financial markets may be prone to credit cycles as
the cost of funds rises and falls for intermediaries.
If, during the course of these cycles, outsiders become
especially skeptical of the value of intermediaries’
investments, then this loss of confidence undermines
the security of both intermediaries and financial
markets.
New England Economic Re~,iew 45
Public m~d Proprietary Assets
Figure 5
Consider the simple case wherein financial markets comprise two types of asset. Assets of the first
EJl/i’ct t!/: Misvaluatiou of Pmt,ictary
type attract many analysts; consequently, most invesAssets o, Equity
tors often hold very similar assessments of the returns
on these assets, and the), tend to trade in broad, deep,
and resilient public markets,r The second type comCapital
prises assets that are not familiar to lnany investors;
accordingly, opinions about these assets generally
diverge, their markets are not dependable, and their
prices can be very volatile. The valuation of these less
familiar assets depends on the role of financial intermediaries, who expect to profit from their proprietary
information by purchasing assets that, in their opinion, are valued too cheaply in public markets,s Other
investors may not value these assets very greatly
L + C2
because, for want of sufficient information, they may
overestimate the risks inherent in these assets and, at
Markel Value of Equity
times, they might underestimate potential returns.
Loans from banks or finance companies, private
placements, venture capital investments, and many
over-the-counter securities are traditional examples of
assets that do not enjoy a broad public following. A
loan to a manufacturing compauy that has little access
to public financial markets commits the lender to the
over the COlnpany’s decisions when necessary may
company until the manufacturer may repay the loan
reduce the cost of funds considerably for the manuwith its own resources or offer securities to other
facturer, even after considering any administrative
lenders at attractive prices. Similarly, the lender may
impositions entailed by the loan. In this respect finannot be able to sell its loan to others without making
cial
intermediaries can promote both the efficiency of
substanfial concessions, unless other investors also are
financial
markets and capital forlnation by reducing
familiar with the company and are at least as optimisthe
bid-ask
spread on securities that are not very
tic about its prospects. Without an informed lender, a
familiar to most investors.
prohibitively high cost of capital may confront the
manufacturer; whereas a private arrangement, with a
lender possessing proprietary information that is rePublic Confidence mtd the Vahte of an
inforced by frequent reports fi’om the company, dilih~termediary" s Equity
gent oversight of the company, and some influence
The capacity of any intermediary to apply its
proprietary information depends on other investors’
7 Many listed securities may not trade in efficient markets.
confidence in the management of the intermediary.
According to IBES, many equities fail to attract the consisteut
Suppose an intermediary acquires an asset whose
atteutiou of very many aualysts. The earnings-price ratios for stocks
tend to be sufficiently high to entail a puzzlingly high cost of equity
risks appear greater to investors outside the interme(Abel 1991). Corporations, especially those with the best ratings,
diary than to specialists within the intermediary, so
seldom raise funds by issuing new equity (Myers and Majluf 1984),
and the correspondeuce betweeu itwestnaeut speoding and cash
that the intermediary’s private valuation exceeds the
flow is surprisiugly strong (Kopcke 1993). The volatility of assets’
public valuation of the asset (Figure 5). Before the
returus seems to be very sensitive to recent "surprises" (for exampurchase of the asset, the value of the intermediary’s
pie, GARCH models). Closed-eud mutual funds frequently sell at
significaut, variable discounts from their oet asset values. Aud,
equity in public markets corresponds to point 1
some coutend that simple trading rules yield excess returns (for
(matching point 2 in Figure 3). After the purchase of
example each Jaouary buy the 10 stocks iu Dow Jones lndustrials
the asset, outside investors perceive that the intermethat have the lowest price-earniugs ratios).
s This proprietary kuowledge is not necessarily shared equally
diary has assumed more risk, so even if outsiders
among all iusiders and does not always eotail a more accurate view
believed the interlnediary were being compensated
(Simous and Cross 1991).
46
Nouembe~TDecember 1995
New Engla,d Economic Review
fairly for its assumption of this additional risk, the line
representing the value of equity shifts downward,
reflecting the increased odds of bankruptcy. The value
of equity in this case would fall to point 2. However,
when the intermediary acqnires the asset for a price
exceeding its public valuation, outsiders also believe
The capacity of any
intermediary to apply its
proprietary information
depends on other investors’
confidence in the management
of the intermediary.
that the intermediary is assuming this additional risk
without receiving a sufficiently great expected return.
Accordingly, the value of the intermediary’s equity in
public markets falls to point 3. Similarly, outside
aualysts who mark the intermediary’s assets accordiug to their valuation in public markets find that their
measure of its capital falls by the distance between
points 2 and 3, which represents the amount that the
intermediary apparently overpaid for the asset.
Of course, the managers of the intermediary acquiring the asset take exception to these discouuts.
Because they believe the risk inherent in the asset is
less than other investors believe it to be, and because
they believe the asset’s expected return is sufficient to
compeusate them for the asset’s risk, in their opinion
the dashed line representing the market value of
equity should not fall as low as the line passing
through point 2. In fact, to the degree the price they
pay for the asset does not fully reflect their private
valuatiou, the intermediary is earning a rent; therefore, in the opinion of its managers, the market value
of its equity should be closer to, and may even exceed,
that indicated by point 1.
The risk premium required of the intermediary by
outsiders limits the ability of intermediaries to "arbitrage" the bid-ask spreads prevailing on securities
that are not very familiar to most investors. The
managers of financial intermediaries may proceed
with their investments expecting that the resulting
excess returns will compensate them for having to pay
greater yields on their liabilities, but the need to cover
Novembe~JDecember 1995
the higher cost of these liabilities, other things eqnal,
warrartts higher returns from their proprietary investments. Higher prices attract fewer takers. Furthermore, sufficiently large differences between the book
value of au iutermediary’s assets and outside analysts’
valnations of these assets threatens mauagement’s
freedom to make its own decisions.
The value of equity does not necessarily fall for all
intermediaries that purchase assets that are uot familiar to other investors. Investors often accept the judgments of those intermediaries with a history of earning of attractive returns, those with strong reputations
for making astute investments, for mauaging risky
investments, and for not investing too greatly in
illiquid assets. Managers deserving this confidence
earn returns that, on average, exceed those available
on other assets of similar risk that are traded in public
markets. The value of equity for intermediaries with
secure repntations tends to exceed their capital to the
degree their shareholders anticipate that they will
continue to earn rents.
Leverage and the Cost of Fu,~ds
If shareholders are more confident or optimistic
than creditors about the investments of a financial
intermediary, the intermediary’s cost of fuuds rises
with its leverage, thereby inducing its management to
set minimal standards for the intermediary’s capital
per dollar of risky assets. Other things equal, these
voluntary capital requirements increase when investors become more wary of an intennediary’s prospects
or the difference between an intermediary’s expected
return on assets and its cost of funds diminishes. In
these cases, management may meet its rising standards by acquiring more capital or by diminishing the
share of its portfolio invested in proprietary assets,
whichever course seems most economical.
The cost of funds for intermediaries depends on
marginal iuvestors’ views of their assets. Suppose
investors are either informed or uninformed about the
prospective return on an intermediary’s assets. If the
intermediary raises funds only from informed investors to finance a given portfolio of assets, its cost of
funds is ri regardless of its choice of leverage because
the investors’ assessments of the returns on this portfolio do not depend on the manner in which it is
financed. UuilffOrlned investors, on the other hand,
require a greater return, r~,, because they anticipate
more risk. For any given degree of leverage, uninformed investors require a greater return on both their
debt and equity than do inforlned iuvestors, but this
N~’w England Economic Review 47
Figure 6
Figure 7
The Cost of Funds
Leverage and the Cost of Funds
Required
Return on
Equily
Marginal Cost/
Average Cost
rU
rU
]
Leverage
See Appendix.
Leverage
b.
Nominal
Yield on
Debt
rs
Leverage
See Appendix.
difference in required yields is greatest for equities
(Figure 6).9
If an intermediary issues liabilities to uninformed
as well as informed investors, informed investors
would tend to own the equity of the intermediary, and
uninformed investors would tend to own its debt. If
the h~termediary, after having exhausted the resources
of informed investors, were to offer both debt and
9 The difference between the returns required on equity is least
when leverage is negligible, a difference equal to the maximum
attained by debt at full leverage. As leverage rises, the difference
between the returns required by uninformed and informed investors on equity rises, because uninformed investors (who anticipate
greater risks than informed investors) require a greater spread
between equity and debt yields, a spread that rises with leverage.
48 November/December 1995
equity to raise new funds, it would offer these securities at higher yields than formerly to attract uninformed investors. Informed h~vestors would perceive
the price of new debt and equity to be comparatively
low, but equities would offer the better bargain. Accordingly, informed investors holding the debt of the
intermediary would exchange their securities for equities, outbidding uninformed investors. After the
available resources of informed investors were invested entirely in equities, the intermediary would
achieve its lowest cost of funds by issuing only debt
instruments to uninformed investors to raise more
funds. In these circumstances, the intermediary’s cost
of funds rises as it expands and increases its leverage
(Figure 7)J° Because each new dollar of debt raises the
rate of interest that the interlnediary pays on all of its
debt, the marginal cost of these funds exceeds the
average cost of funds. If the intermediary were to issue
both new equity and debt to uninformed investors, its
average cost of funds would rise abruptly, and, with
this sale of equity, its marginal cost of funds, especially in the opinion of shareholders, would rise even
more abruptlyJ~
~o Once leverage becomes too great, the h~termediary, in principle, might minin’6ze its average cost of funds by issuing new
equity, but doing so entails substantial capital losses for existing
shareholders. Accordingly, tbe institution’s voluntary standards for
capital ought to limit leverage, in order to avoid the potential
expense of having to issue new equity.
~ The prices of both equity and debt in competitive markets
would be set by the uninformed h~vestors, who, in this case, would
New England Economic Review
Because investors’ opinions of an h~termediary’s
prospects generally span the spectrum of optimism,
price-discriminating intermediaries minimize their
cost of funds by issuing many different types of
liabilities that offer many different blends of expected
returns and risks. Their equity is held by the most
optimistic investors, while preferred stock, debentures, notes, paper, investlnent contracts, deposits,
and repurchase agreements are held by others who
value an increasing degree of security. Retained cash
flow (representing the implicit investment of funds by
the most optin-fistic investors) and rights issues remain
the least expensive source of funds (Duesenberry 1958;
Myers 1984; Myers and Majluf 1984; Harris and Raviv
1991).
Bankruptcy costs reinforce the tendency for the
cost of funds to rise with leverage, once leverage
becomes sufficiently great. The markets for intermediaries’ proprietary assets are not very liquid, especially
when the primary specialists in these assets, as a result
of their own financial duress, no longer are h~vesting
actively. Accordingly, ~vhen investors are not informed equally well about the assets acquired by
financial intermediaries, the potential cost arising
from the bankruptcy of an intermediary can greatly
exceed those presented in section I, as a result of the
new owners’ need to manage unfamiliar proprietary
assets or to sell these assets in illiquid markets to other
wary investors. The expense of h~suring creditors
against this cost of bankruptcy becomes substantial
after an intermediary’s capital per dollar of risky
assets falls sufficiently low, thereby raising the odds of
bankruptcy. In this case, issuing new equity, even to
relatively wary investors, is more economical than
issuh~g new debt.12
marginal return on assets were less than the marginal
cost of funds, the value of the intermediary’s equity
would diminish with any further expansion of its
portfolio.
Those intermediaries with the best reputations
and, therefore, the lowest cost of funds would be able
to expand and to lever themselves the most. A good
reputation reduces an intermediary’s marginal cost
of funds in two ways. First, investors require lower
returns on the intermediary’s liabilities. Second, as the
intermediary expands, the least optimistic h~vestors
do not require returns very much greater than the
most optimistic investors.
Suppose two intermediaries expect yields of 10
percent on their proprietary assets, and insiders require a constant average cost of funds of 4 percent,
regardless of leverage. If these intermediaries could
rely solely on insiders for their financing, their marginal cost of funds would be a constant 4 percent. The
The optimal choice of leverage
balances an intermediary’s cost of
funds against its assessment of
the prospective return on its
potential investments.
The optimal choice of leverage balances an intermediary’s cost of funds agah~st its assessment of the
prospective return on its potential investments. For
example, the management of an intermediary could
expand its investments until its marginal return on
assets equals its marginal cost of funds. Although
managers might believe that outsiders impose too
great a hurdle rate given the risks (as the managers
perceive them) ird~erent in their assets, if the expected
ample investlnent opportunities for both, however,
compel them to sell debt to outsiders. The good
reputatiou of the first intermediary among outsiders
allows it to raise $10 million of debt at no premium
over the yield required by insiders on their debt, $20
million of debt at a pren-fium of 1 percentage point,
$30 million at a premium of 2 percentage points, and
so forth. The weaker reputation of the second allows
it to raise $10 million at no premium, $20 million at a
prelnium of 2 percentage points, and so forth. The
marginal cost of funds for the first intermediary is 4
percent for the fh’st $10 million of debt that it issues.
For the next $10 million the marginal cost of funds
rises to 6 percent: The second $10 million not only
costs a premium of I percentage point itself, but it also
raises the premium on the first $10 million from zero
be the marginal investors. New equity sold at a discount sufficient
to attract uninformed investors (especially when the reputation of
the intermediary is questionable) would impose substantial losses
on previous shareholders.
~2 The intermediary could reduce the cost of raising new capital
somewhat by issuing different classes of equity or other liabilities
(such as subordinated debt) that might: (1) be recognized as capital
by senior creditors and supervisors, and (2) offer new investors
more security than commou stock.
Voluntary Standards for Capital
November/December 1995
New England Economic Review 49
to 1 percentage point. The marginal cost of funds rises
to 10 percent with $40 million of debt: the last $10
million requires a premium of 3 percentage points
itself, and it raises the premium on the previous $30
million by 1 percentage point, which adds another 3
percentage points to the cost of the last $10 million.
The second intermediary issues no more than $20
million of debt; otherwise, its marginal cost of funds
would exceed 10 percent. This intermediary can diminish, but not entirely avoid, the burden of its
handicap by issuing different liabilities to different
investors.13
An intermediary that suffers a loss of reputation
may cope either by diminishing its investments in
proprietary assets or by issuing new equity. The
former is frequently the most economical course. If the
marginal cost of debt is too expensive, equity is not
likely to be a bargain, because a loss of confidence
increases the cost of equity more than that of debt. If
the intermediary sold those assets that are most familiar to outside investors, it would only increase its
marginal cost of funds as the proportion of its liabilities backed by questionable proprietary assets increased. If, however, outsiders discounted the value of
proprietary assets too greatly, so that selling these
assets entailed substantial losses and the intermediary’s capital were sufficiently low to raise the risk of
bankruptcy, management would need to issue new
equity.14
Financial Fragility, Credit Crunches,
and Systemic Risk
The financial system becomes more fragile as
public investors who formerly accepted intermediaries’ valuations of their proprietary assets become
skeptical of those valuations,l~ Even the best investors
ultimately stiffer runs of bad luck wherein too many
investments yield disappointing returns for too long,
encouraging outsiders to question whether the returns
are adequate for the risks inherent in these proprietary
investments. Intermediaries that expect to earn greater
rents by not paying their "full price" to obtain their
proprietary investments, retain more "capital" for
protection against the consequences of disappointing
returns. A bad run would diminish, but not necessarily eliminate, the value of an intermediary’s equity
relative to that of its capital (the value of equity would
tend to remain above point 1 in Figure 5). If the desire
to meet or beat the competition causes an intermediary to bid full price for its proprietary assets, it retains
less capital in the form of expected rents, putting the
50 November/December 1995
valtte of its equity at greater risk should it experience
a run of disappointing earnings (the value of equity
could approach point 3 in Figure 5).~6
A loss of confidence creates a credit crunch, as the
cost of fnnds for affected financial intermediaries rises
compared to yields prevailing in public markets.
A loss of confidence creates a
credit crunch, as the cost of
fl~nds for affected financial~
intermediaries rises compared to
yields prevailing in public markets.
When outsiders discount the value of an intermediary’s proprietary assets, the value of its equity falls,
as creditors require greater risk premiums. Intermediaries respond by reducing their leverage and their
investments in assets for which managements’ and
outsiders’ assessments diverge the most. In turn, the
cost of funds rises sharply for businesses and consumers who depend on this intermediary for their
financing (Gurley and Shaw 1955, 1956, 1960; Tobin
~3 This exmnple illustrates why differences between yields on
private debt and Treasury debt might not indicate consistently the
magnitude of credit crunches, and it suggests that changes in these
differences may reflect more than changes in monetary policy.
Suppose the cost of funds for the first intermediary rose to match
that of the second intermediary o~ving to a sequence of disappointing earnings or growing fears of such disappointments. In this case,
the intermediary would reduce its investments and diminish its
leverage; yet, after this adjustment, the average cost of its debt in
public markets would not rise, but fall--its average premium on
debt drops from 3 to 2 percentage poh~ts. If a tighter monetary
policy (higher safe rates of interest) accompanied the shift in
confidence, the intermediary’s yield on debt would fall less than
indicated above or might even rise; nonetheless, any change in
quality spreads would reflect the changing assessments of both
insiders and outsiders. Ironically, the more skeptical outsiders
become, the greater is the ensuing credit cruuch, and the less quality
spreads may rise as intermediaries reduce both their leverage and
their investing in proprietary assets.
~4 The value of shares should fall well before the public
offering, as existh~g shareholders who anticipate this need to issue
new equity and who hope to limit their losses might sell their shares
to outsiders. Therefore, intermediaries’ voluntary capital standards
should become binding well before the need to issue equity to
outsiders becomes very great.
~ The recent experiences of banks in Texas, New England, and
Japan may illustrate such crunches (Furlong 1992; Peek and Rosengren 1995a; Bizer 1993; Bernanke and Lown 1991; Berger and Udell
1994; Hancock, Laing, and Wilcox 1995).
~ Those whose bids reflect their full valuation of an asset,
"will, in the long run, be taken for a cleaning" (Capen, Clapp, and
Campbell 197I). See also Thaler (1988).
New England Economic Review
1963; Bernanke and Gertler 1987). This crunch is most
severe for intermediaries that hold the least capital per
dollar of assets and those that retain less rent when
purchasing proprietary assets. Intermediaries for
~vhich these resources are most ample are best able to
adjust in a timely manner, perhaps postponing shrinking until their reputation is restored.
The rent embedded in the yields on intermediaries’ proprietary investments can be considered a premium for insuring access to funds for their customers
at reasonable terms. The need for this insurance is not
compelling when public confidence in the management of financial intermediaries is strong. Accordingly, when all are optimistic, competitive pressures
among intermediaries placing funds and customers
seeking funds may diminish the writing of this insurance against credit crunches; borrowers want the best
yield, and lenders want the volume. In these circumstances, any attenuation of public faith in intermediaries threatens a greater degree of financial fragility
and more severe crunches (Sharpe 1990; Slovin,
Shuska, and Polonchek 1993; Gibson 1995).
Systemic risk arises when the value of assets falls
well short of expectations at many financial intermediaries at nearly the same time. Of course, the failure
of one intermediary to meet its obligations may start
a chain reaction if many intermediaries invest very
greatly in each other’s liabilities. But the ties need not
be so explicit. For example, the failure of one bank
might kindle duress at others if all had taken similar
risks by investing a considerable proportion of their
assets in loans to similar borrowers or similar industries. The potential for systemic risk increases when
the need to establish strong reputations or accumulate capital encourages intermediaries to emulate winners, impelling all to report returns matching those of
their most successful competitors. Systemic risk diminishes as intermediaries invest in more diverse
assets and mah~tain adequate profit margins on their
investments.
III. Heterogeneous Opinions and the
Consequences of Regulation
According to the analysis of section I, when all
investors assess the potential returns on all assets the
same and when capital markets are competitive, regulations that govern the risks and leverage assumed
by financial intermediaries are of little consequence
unless they alter the net yields on assets through taxes,
reserve requirements, or mispriced insurance fees. If,
November/December 1995
however, investors are not equally well informed
about the prospective returns on all assets, the terms
on which financial intermediaries are able to issue
their liabilities or acquire assets depend considerably
on the regulations governing their financial structure.
Regulations that in some circumstances seem
prudent and conservative do not necessarily promote
safe and sound financial institutions or economic
stability if, in other circumstances, they diminish the
capacity of intermediaries to absorb financial shocks.
Regulations that in some
circumstances seem prudent and
conservative do not necessarily
promote safe and sound financial
institutions or economic stability
if, in other circumstances,
they diminish the capacity of
intermediaries to absorb
financial shocks.
Regulations such as capital requirements influence the
cost of funds for intermediaries, and the burden of
these requirements can vary substantially with outsiders’ state of confidence. Although the conflation of
fixed capital requirements with the marking of assets
according to their market values promotes secure
intermediaries when all investors possess the same
information about intermediaries’ assets, these policies can increase the volatility of intermediaries’ cost
of funds when outsiders are not informed fully about
the prospects for interlnediaries’ proprietary assets.
Because regulations affect the price of risk in financial
markets and because this influence varies with economic conditions, the most promising regulatory policies seemingly would stabilize financial markets best
by managing the price of risk in order to foster an
appropriate flow of savings and investment, rather
than by attempting to set absolute standards in order
to judge the safety and soundness of intermediaries.
Capital Requirements
When investors are not informed equally well or,
for other reasons, perceive the returns of intermediarNew England Economic Review 51
ies’ assets differently, the setting of minimum standards for the capital of intermediaries must balance
the potential benefit of safer financial institutions
against the cost of more expensive funds for those
who rely on interlnediaries for their financing.
The potential benefits of regulating standards for
capital are small unless creditors underestimate the
risks assumed by fh~ancial intermediaries. If creditors
require a premium that is too great, intermediaries
restrict their purchases of assets more than necessary
because of their greater cost of funds. Altering capital
requirements alone would not alleviate such a credit
crunch. If creditors require a premium that is too small
for the risks they bear, intermediaries would expand
more than otherwise. These circumstances may arise
when creditors expect governments or others to indemnify them should their intermediary fail and
when those who purportedly write this put option
receive an insufficient premium from the intermediary
to cover this liability. For example, if investors believed that the government regarded certain banks or
insurance companies as too important to fail, then
these institutions’ u~nsured creditors would not require adequate risk premiums of these intermediaries.
Capital requirements may limit the risks that
intermediaries transfer to others, but, in principle,
these requirements must be flexible if they are to
substitute for fair risk premiums. Proper capital requirements should induce intermediaries to assume
the degree of leverage that they would have assumed
if creditors and their guarantors required properly
priced risk premiums (Figure 8). Suppose that, in the
opinion of fully informed investors who bear the full
risk of their investments, the marginal cost of funds
equals the marginal return on assets when an intermediary’s leverage is 1o. IL however, creditors do not
require adequate risk premiums, the margh~al cost of
f~mds falls (the dashed line), and leverage rises to l~.
When capital requirements compel intermediaries to s~vitch from debt to equity financing before they
reach their voluntary standards for lninimum capitalization, these requirements increase intermediaries’
cost of h_mds substantially. Should regulators require
that leverage not exceed 12, an intermediary’s cost of
funds would rise (the dotted line), thereby inducing it
to maintain leverage nearer 1o. The cost of funds rises
sharply before reaching l2 as the odds of having to
raise more equity increase when 1 approaches l2. The
more steeply the cost of funds rises near 12 (due to
the added expense of equity financing), the closer [2
should be to lI in order to achieve leverage very near
Io. The choice of 12 presumes both that regulators
52 November/December 1995
Figure 8
Capital Requirements, the Cost of Funds,
and Optimal Leverage
Yield
Marginal Cost of Funds with
I Appropriately Priced Insuran.~e I ~
Marginal Cost of Funds with
Capital Requirements I
~
1
I
Marginal Return-]
~/
on Assets I
~Y"
Marginal Coat of Funds with
Underprced nauraece
Ic
~
~
1
Leverage
understand that the appropriate leverage is lo and that
they know how greatly the cost of funds rises with
the switch from debt to equity financing. In order to
maintain an appropriate flow of funds on proper
terms, capital requirements should change as both the
returns and risks inherent in an intermediary’s proprietary investments change, as the "subsidy" implicit
in the returns required by creditors changes, and as
the "premium" for selling equity to outsiders changes.
FLxed capital requirements tend ~o exaggerate the
credit cycles that arise as the oph~ions of outside investors vary from optimism to pessimism during business cycles (Blum and Hellwig 1995). At times when
outsiders are particularly optimisfic about the earnLegs of h~termediaries, fLxed capital requirements wonld
entail a comparatively low cost of funds, encouragh~g
intermediaries to expand comparatively rapidly when
the prospects for the economy are attractive. At times
when outsiders are particularly skeptical, requirements would impose a comparatively great cost of
funds on intermediaries and their proprietary investments, thereby increasing the magnitude of credit
crunches when the outlook deteriorates.
Adjusting capital requirements or the powers of
intermediaries seems to be an awkward means of
regulating intermediaries’ risk. When savers are too
New England Economic Rez,iew
optimistic about the returns that will redound to
intermediaries, greater minimum capital requirements
might prevent insufficient risk premiums from inciting
speculative booms. Perhaps requirements might be
raised most for the "riskiest" assets, those riding the
greatest bubbles. Conversely, capital requirements
might be redttced when savers are too pessimistic. Yet,
this policy depends on regulators’ ability to recognize
bubbles before others and to enforce new capital
requirements. In any case, requiring intermediaries to
raise more capital when outsiders are most willing to
acquire their shares at high prices would seem to be a
weak deterrent to speculative booms, and requiring
less capital when savers are most concerned about the
security of intermediaries’ liabilities would seem to be
a weak spur to confidence. The countercyclical adjustment of intermediaries’ powers for making certain
investments would pose similar problems.
Fixed capital requirements tend to
exaggerate the credit cycles that
arise as the opinions of outside
investors vary from optimism to
pessimism during business cycles.
To measure and control the risks of financial
intermediaries, especially those of banks and insurance companies, regulations favor risk-based capital
requirements (Spong 1994, pp. 70-82; Webb and Lilly
1994; Barth 1995; Cummins, Harrington, and Niehaus
1994). According to this policy, an intermediary holds
capital in proportion to its investment in assets that
are designated risky, but it might not hold capital in
proportion to the risks that it assumed in its entire
balance sheet (Grenadier and Hall 1995). These requirements, which currently dwell ahnost exclusively
on credit risks, take into account neither any diversification of investments that might mitigate these risks
nor any exposure to risks created by changing interest
rates and other yields on assets.~7 Safe balance sheets
might be burdened with excessive capital requirements: A portfolio of assets offerh~g a relative safe
return might comprise a blend of risky assets ~vith
offsetting risks. Conversely, risky balance sheets might
enjoy especially lenient capital requirements: A safe
asset, such as a govermnent bond, might be financed
with short-term loans, thereby creating considerable
November/December 1995
risk for the intermediary and its creditors. Risk-based
capital requirements also entail an implicit tax, creating a kind of credit control, on those assets that are
designated as risky, often the proprietary assets of
intermediaries. This tax, which reflects the cost of
equity financing, becomes especially burdensome during credit crunches. Accordingly, risk-based capital
requirements encourage intermediaries to reduce their
investments in these designated assets comparatively
greatly during crunches, despite their success in controlling the risks in their balance sheets.
Accounting for Capital
The gravity of the tax implicit in capital requirements depends on the rules that govern how intermediaries measure their capital. If the managers of
intermediaries are best informed about their proprietary assets for which markets too often are shallow or
illiquid, markh~g all assets according to market prices
undermines the efficient flow of funds in financial
markets by supplanth~g the opinions of specialists
with those of less hfformed investors. Market prices
in these circumstances can be biased estimates of the
values of proprietary assets.~s As the optimism of
outsiders rises, prices of these assets may nearly meet
or exceed proprietary valuations for a time, only to fall
below proprietary valuations when this optimism
subsequently ebbs. This potential volatility of outsiders’ valuations for proprietary assets induces a commensurate volatility of intermediaries’ capital with
market accounting. Banks in Texas, New England, and
Japan, for example, possessed more than adequate
protection when the value of enterprises and real
estate backing their assets was very great, but this
capital eroded quickly when the prices of these assets
collapsed.
Not only does a loss of confidence that reduces
the value of capital in this manner raise the cost of
funds for any given leverage (the dotted line in Figure
8 shifts up when leverage is near to or greater than 12),
~7 Banks and other intermediaries traditionally have pttrsued
profits by "taking a view" of market trends or by "riding the yield
curve." In the recent recovery, intermediaries invested a substantial
share of their assets in longer-tem~ Treasury securities in anticipation of falling interest rates. The risk in this strategy entailed no
extra capital assessments; instead, to the extent intermediaries
reduced their commitments to lower-grade bonds, mortgages, or
equities, their capital requirements were diminished.
~s When no true prices are quoted in markets for assets,
supervisors often resort to prices of comparable assets, prices
derived from models, or book values of assets net of estimates of
losses (due to default or workouts).
New England Economic Review 53
but, with market accounting, the loss of confidence
also raises the cost of funds by increasing leverage
(increasing 1). When the prices of proprietary assets
are particularly high, the cost of funds is comparatively low (I tends not to exceed 12), encouraging
intermediaries to issue more debt and expand their
assets by offering comparatively attractive terms to
those seeking funds. When the prices of proprietary
assets "break," so does the capital of intermediaries
(if I were near /2, it would rise above 12), abruptly
increasing the cost of funds.
Marking both assets and liabilities according to
market values does not necessarily salvage market
accounting, partly because ratios of capital to assets,
however defined, are designed to measure neither the
risks assumed by intermediaries nor their capacity for
protecting creditors from losses (Merton 1995; Berger,
Herring, and Szeg6 1995). Insurance companies each
holding $10 million of 30-year mortgages financed by
$1 n-fillion of capital and $9 million h~ cash value life
h~surance policies have the same capital ratios. But
those companies that impose sufficient call prelrdmns
on policyholders who try to withdraw funds are
protected better should interest rates rise tmexpectedly. Similarly, companies that include sufficient call
premiums in their mortgage loans are better insured
against the risk of falling interest rates. Capital ratios
measure neither the insurance embedded in intermediaries’ portfolios nor the rate at which this insurance
coverage might change with economic conditions.19
Alternative assessments of the "capital" of portfolios examine how their earnings and cash flows
change with economic conditions. These sensitivity
tests implicitly weigh the consequences of: (1) the
options assumed by intermediaries, including those
embedded in their assets and liabilities; (2) the mismatches in their books between long and short commitments at various maturities; (3) the correlation of
returns among assets and liabilities; and (4) the possibility that the prices of some assets collapse and their
maturities increase for want of dependable markets.
These tests should be dynamic, incorporating managements’ responses to changing conditions and covering
intervals of time sufficiently long to encompass the full
consequences of these changing conditions. Because
the need for insurance arises precisely because investors are not all fully informed and markets are not
dependable, these approaches might understate the
risks that arise when the confidence of outsiders shifts,
bringing surprisingly sharp changes in the prices of
riskier assets while changing the customary covariances among their returns and perhaps those among
54 November/December 1995
more liquid assets as well. Consequently, risk managers and supervisors should use the simulation model
behind these tests to isolate an intermediary’s bets-that is, to isolate those economic conditions that will
threaten its solvency--so that they may assess its
potential risk.2°
Prompt Enforcement of Capital Requirements
Current strategies for regulating financial institutions rest on the prompt enforcement of risk-based
capital requirements.2~ Policies for enforcing capital
requirements that promote sound financial institutions in some circumstances might fail to do so in
other circumstances. For example, the prompt enforcement of minimum capital requirements using market
value accounting is a conservative policy when the
markets for financial instruments are liquid. It also
can be an efficient means of levying a fair liabilitiy
insurance premium, as discussed in section I. Yet, the
prompt enforcement of capital requirements tends to
weaken h~termediaries when outsiders are most skeptical of the returns on their proprietary assets and the
prices of these assets understate their value significantly. Accordingly, the prompt enforcement of capital requirements also might not reduce the potential
liabilities of agencies that guarantee the liabilities of
intermediaries (Gilbert 1992).
If risky assets were priced efficiently, their prices
would resemble random walks (Cootner 1964; Merton
1990). Tomorrow’s news would be no more likely to
~9 In the language of options, capital ratios do not convey the
deltas, the gammas, or any of the other "Greeks" embedded in a
balance sheet.
~_o Value-at-risk calculations essentially weight these events
according to odds chosen by management. Even if the managements of all intermediaries assigned the same odds to the same
events, supervisors might not agree ~vith these assessments. A
conservative policy, for example, might require that intermediaries
adopt policies that keep their maximum losses for "reasonably
likely" events below some minimum set by supervisors.
If intermediaries are portfolios of functions that differ mainly in
the blends of fi_~nctions they offer their customers, then level playing
fields and efficient markets might require functional regulation that
spans intermediari6s. Even so, the risk in a portfolio is not a simple
snm of the risks in its constituent functions. The auditing of risks
described in this paragraph, therefore, requires more universal
supervision.
~ Following a 1988 agreement on capital requirements among
the United States and other developed economies and the Federal
Deposit Insurance Corporation Improvement Act of 1991, the supervisory standards that apply to each bank depend on its regulators’ rating of the adequacy of its capital (Spong 1994, pp. 70-82). In
practice, however, regulators of banks appear to h~tervene earlier
and with more discretion than the risk-based capital provisions of
FDICIA would suggest (Peek and Rosengren 1995b; Jones and King
1995).
New England Economic Review
increase the value of these assets more than expected
than to decrease their value more than expected.
When intermediaries purchased these assets, prudent
supervisors might require that they be marked according to their market values, because they would be no
more due for redeeming gains after suffering substantial losses than they would be due for further substantial losses. A very conservative policy also might
require that capital equal 100 percent of the value of
proprietary assets so that creditors bear none of their
risk (Friedman 1959; Tobin 1985; and Litan 1987). This
need for 100 percent capital requirements diminishes
if supervisors compel intermediaries to practice a form
of portfolio insurance, responding promptly to any
losses by raising new capital or by selling some risky
assets (Fortune 1995). With such a policy of prompt
enforcement, the more frequently risky assets are
appraised and the less volatile are their prices, the less
capital is required.
When shareholders regard raising new capital
from outsiders to be very expensive, regulators have
another reason to enforce promptly their standards for
capital, including seizing the assets of intermediaries
The prompt enforcement of
capital requirements is not
necessarily a conservative policy
when markets are not liquid.
that are nearly insolvent even though their capital is
not exhausted. When an intermediary’s capital is
nearly depleted, shareholders may increase the value
of their equity either by raising new capital or by
assuming more risk, thereby increasing the value of
the put option created by the shield of limited liability
(Figure 2a). If creditors and guarantors do not raise
their risk premiums promptly as shareholders assume
more risk, then shareholders have little to lose by
taking riskier investments, and they have much to
gain should these investments produce high yields.
When regulators seize the assets of the intermediary,
they essentially are charging the shareholders a premium that covers the risk of the shareholders’ taking
such a strategy.
Nonetheless, the prompt enforcement of capital
requirements is not necessarily a conservative policy
when markets are not liquid. If proprietary assets are
November/December 1995
not priced efficiently, their values may not follow
random ;valks. When outsiders are most optimistic,
the prices of these assets may nearly match or exceed
informed valuations; when outsiders are most wary,
their prices may fall well below these valuations.
Therefore, the prices of these assets tend to revert to
trends: Once a price falls below its proprietary valuation, the odds of its returning increase with time,
while the odds of its falling further diminish. The
prompt enforcement of capital requirements may even
magnify the degree to which the prices of these assets
diverge from trends. If, for example, an intermediary
must sell proprietary assets in order to restore its ratio
of capital to risky assets after the prices of these assets
subside in the opinions of outsiders, then these prices
will fall further in illiquid markets. After the prices of
proprietary assets fall substantially, thereby increasing
an intermediary’s leverage, the chance of redeeming
capital gains increases with time, while the chance of
commensurate losses diminishes. Therefore, when the
value of an intermediary’s assets approaches that of its
obligations and its liabilities are of sufficiently long
duration, its expected losses due to insolvency may be
lo~v compared to the expected gains from retaining
these assets (the divergence between points 1 and 3 in
Figure 5 is especially great).
Suppose an intermediary attempts to maintain a
ratio of capital to assets of 10 percent, while investing
40 percent of its assets in proprietary investments, 60
percent in safe assets. Because creditors believe the
intermediary’s liabilities are insured adequately, the
yield on these accounts equals the yield on safe assets.
The prices of proprietary investments follow a
smoothed random walk: A below-average return on
these assets creates no expectation of compensating
above-average returns subsequently.2~- When favorable earnings increase its capital per dollar of assets,
the intermediary sells more accounts, investing the
funds as required to maintain the 3:2 ratio between its
safe and risky assets. When poor earnings reduce its
capital per dollar of assets, the intermediary sells no
new accounts and acquires no new risky debt. The
capital of this intermediary approaches zero, on average, nearly twice every one hundred years (Figure 9a).
When the intermediary practices portfolio insurance,
selling risky assets as required in order to prevent the
22 This example uses a colored random walk with drift. The
news that yields higher (or louver) than average returns in one year
tends to yield higher (or lower) returns in subsequent years, albeit
by an amount that diminishes with time. Despite these short-run
cycles, in the long run the probability distribution of the value of an
initial investment in the asset approaches a random walk.
New England Economic Review 55
Figure 9a
Capital Ratios l~enP~""’~
~, of. Assets Follow a Random Walk
Ral~o ol Capilal Io Assels
.25
.20
.15
.]0
.05
-.05
50
100
150
200
250
300
350
400
450
Years
Figure 9b
Capital Ratios When Prices of Assets Follow a Random Walk and
Capital Requirements Are Prompth,/ Enforced
.25
Rali¢, ol Capital to Assels
.2O
50
56 November/December 1995
100
150
200
250
300
350
400
450
Yea~s
New Enyland Economic Review
Figure 9c
Capital Ratios When Prices qf Assets Revert to Trend
.25
Ratio of Capital Io Assets
.2O
.15
.10
.O5
0
-.05
50
100
150
200
250
300
350
400
450
Yeals
Figure 9d
Capital Ratios When Prices of Assets Revert to Trend and
Capital Requirements Are Promptly Enforced
.25
Ralio of Capilal Io Assels
.2O
,15
¯I0
.05
-.05
50
100
150
200
250
300
350
400
450
Yeals
See Appendix.
November/December 1995
Nero England Eco~omic Review 57
ratio of risky assets to capital from exceeding 4, then
the intermediary’s capital approaches zero less than
once every century (Figure 9b).
Although the prompt enforcement of minimum
capital standards makes intermediaries more secure
when the prices of their assets follow random walks,
this policy can undermine their security when their
proprietary assets are not ahvays liquid. If the values
of proprietary assets tend to return to trend--a run of
below-average rettu’ns increases the odds of earning
above-average returns--the capital-to-asset ratio almost uever approaches zero with the investment strategy described in the first simulation (compare Figure
9c to %), even though the annual volatility of the rate
of return on proprietary assets is greater than in the
first case. If, in this last instance, the intermediary
practices portfolio insurance by selling some of its
risky assets after their values decline and if the disposal of these assets temporarily reduces their prices
by an additional 10 percent, then the interlnediary’s
average capital-asset ratio (Figure 9d) falls and becomes more volatile. Consequently, the iutermediary’s
capital approaches zero more frequently, about once
every century, wheu it sells its risky assets at distressed prices in order to meet its capital requirements. Furtherlnore, this policy of promptly enforcing
capital requirements induces a clear credit cycle: The
lending capacity of the intermediary, as reflected in its
capital per dollar of assets, falls further and remains
depressed longer in this last case than it did in the
former.
Supervisio~ and Liability h~surance
Insuring the liabilities of financial intermediaries
can make financial markets more efficient both by
reducing the excessive risk premiums that outsiders
might require of intermediaries and by diminishing
the volatility of this preminln over time. In order to
achieve this efficiency, however, guarantors must
make informed assessments of the risks entailed by
intermediaries’ commitments, so that each intermediary’s insurauce prelninm corresponds to its risks. To
the degree the coverage of liability insurance is not
complete--creditors bear some of the losses arising
from insolvencies--or to the degree guarantors assess
the values of proprietary assets the same as lessinformed investors, then the cost of funds for financial
intermediaries becomes more dependent on the outsiders’ state of confidence.
Financial intermediaries would be superfluous if
savers were expected to evaluate the assets of inter58
Novelnbe~jDecember 1995
mediaries before purchasing their liabilities. Interlnediaries can offer savers considerable economies of
scale as their specialists divide the cost of their research and managelnent among many savers. These
economies would be lost if each saver then evaluated
with "due diligence" the assets of intermediaries. But
here too, savers can realize economies by relying on
the expert opinions of analysts and snpervisors who
review the skills of intermediaries’ specialists and the
performance of their investments.
Neither analysts uor supervisors, however, are
disinterested referees (Stigler 1971). Analysts nmst
gain the confidence of their customers. Intermediaries
can shun those they regard as unfair, thereby denying
these analysts important information. Investors similarly will be reluctant to hire analysts who fail to
anticipate and promote what seems to be the next
best investment. The reputation of supervisors, as the
name implies, rests on the reputation of the intermediaries they examine, which tends to restrain the vigor
of supervisors’ criticism and promote too lnuch tolerance (Stewart 1991; Kane 1995).
Analysts, by disclosing their expert criticism, may
foster a deeper and broader tmderstanding of intermediaries’ finaucial strategies among outside investors. Although this understanding may stabilize public confidence in intermediaries, it also may be fragile.
When many banks, insurance companies, and finance
companies profited from the commercial real estate
boom during the 1980s, for example, many analysts
applauded their strategies while questioning the acumen of those who did not invest in these assets. In the
ensuing bust, analysts were very critical of those
holding very many commercial mortgages or other
investments backed by commercial real estate. In
retrospect, both the accolades and the ceusures often
were exaggerated.2-~ The ability of analysts to build a
durable foundation for the confidence of outside investors also is limited by analysts’ limited access to
intermediaries’ proprietary information (Randall 1989).
Supervisors work in confidence, usiug their regulatory authority to enforce their standards. Although
supervisors, in principle, can review the investments
of intermediaries more intimately than analysts, practical limitations on their capacity for discovery encour~-3 Analysts and rating agencies essentially impose their own
risk-based "capital requil’emel~ts." The less formal "questioning" of
banks and insurance companies investing in low-grade or highly
leveraged debt, conlnlelcial lnortgages, derivatives, and certain
equities generally preceded formal regulations. Today, a diminished reputation among analysts can augmel~t the already considel’able bul’den of formal capital reqoirements for intermediaries.
New EnglmM Ecomnnic Review
age supervisors also to rely on regulations confining
the powers of intermediaries, ill order to maintain
safety and soundness (Buser, Chen, aud Kane 1981).24
Furthermore, supervisors, like the interlnediaries they
oversee, may be inclined to take bets. The dimensions
of the past savings and loan crisis were known long
before it made the headlines (Kopcke 1981; Carron
1982); yet, supervisors and government officials, who
were aware of the problem and worried by its potential cost, have been accused of allowing the indnstry to
grow despite its lack of capital in hopes that future
profits would restore its health (Kane 1989).
Supervisors have relied on regulatious in order to
limit the risks borne by il~termedial’ies because, even if
guarantors were collecting adequate premiums for
insuriug their liabilities, frequent or very expensive
failures would suggest that interlnediaries were not
sufficiently safe or sound to outside investors. With
fail" prelninms, the gual’antors’ expected obligations
In order to make financial
markets as efficient as
possible, each intermediary’s
insurance premium ought
to depend on the risks
entailed by its commitments.
would equal their premium receipts, but these premiums would control neither tile frequency of failures
nor the amount of their expected losses. In other
words, fair premiulns fix the expected value of guarantors’ losses at zero, but fair premiums by themselves
do not control the variance of these losses. If guarantors were to report substantial losses, outsiders might
question the ability of their guarantors to insure tile
value of their liabilities, thereby defeating tile purpose
of liability insurance. Furtherlnore, failures engender
administrative costs, similar to bankruptcy costs, that
tend to make iusurance programs excessively expensive when insolvencies occur too frequently. Ill these
circumstances, surviving intermediaries and their customers, who often bear a substantial share of these
extraordinary costs, would benefit from regulations
that lilnit each interlnediary’s ability to assume risk.
Adopting lnore extensive rules to lilnit intermediaries’ powers is no longer a prolnising remedy.
From the 1930s to the 1970s, regulations controlled
November/December 1995
both the assets and liabilities that interlnediaries
might issue and the competition among intermediaries. To the degree regulations protected the rents of
each intermediary, they fostered safe and sound financial institutions at the cost of hiudering the fiexibility
and efficiency of financia! markets. This lack of flexibility subsequently weakened interlnediaries once
bigb rates of infiation and high rates of interest
reduced or eliminated their rents, COlnpelling tbeln to
cultivate new opportnnities for profit. Regulations
setting greater standards for capital ouly impelled the
decline of other regulations that limited the powers of
intermediaries. As il~termediaries evolved, supervisors increasingly bare fotmd themselves auditing
risks rather than enforcing regnlations that define
intermediaries.
Liability insm’ance may be considered a performance contract between the snpervisors and creditors
of financial intermediaries: Supervisors not only assess the risk, but supervisors as guarantors also indelnnify creditors against default, bearing the consequences of any mispricing of this insnrauce. In order
to make financial markets as efficient as possible, each
intermediary’s insurance premium ought to depend
on the risks entailed by its commitments. Creditors
who value this service purchase insured liabilities,
accepting the safe rate of interest. Interlnediaries also
would prolnote these insured liabilities if, iu their
opinion, outsiders generally require excessive risk
premiunls on their uninsured accounts. Although
guarantors may not assess risks as optilnistically as
managers of intermediaries, their confidential audits
lnay allow them to levy premiums lower than those
required by most creditors, especially when outsiders
are most skeptical of the value of intermediaries’ assets.
For this liability insurance to be as efficient as
possible, guarantors should be able to obtain funds on
reasonable terlns at times of financial distress. Guarantors, most likely, will require assistance at those
times when their insured intermediaries are experienciug substantial losses, tilnes when the threat of a
severe credit crunch or systelnic failnre is great and
eveu the most optimistic outside investors are most
skeptical of the value of intermediaries’ assets. On
these occasions, guarantors essentially exercise clailns
against the capital of snrviving intermediaries. Surviviug interlnediaries might avoid incurring this addi~_4 Because surviving banks or insurance companies eventually
are liable for paying some of the claims against insovent interlnediaries (a restoration of the insurance fund), insured intermediaries
themselves benefit from supervision that limits these potential
claims against their capital.
New Englaud Economic Review 59
tional expense if the guarantor conld obtain financing
on favorable terms from a "lender of last resort," such
as tbe government, or from healthy interlnediaries
possessing sufficient resources.2~
IV. Regulatory Policy and Monetary Policy
When financial markets are competitive and all
investors assess the prospective returns on each asset
similarly, regnlation cannot make intermediaries safer
or sounder, becanse all investors are able to tailor their
risks to their tastes, and all are compensated uniformly for those risks that they assnme. Regulations
that set standards for intermediaries’ leverage or that
govern intermediaries’ abilities to purchase assets or
write liabilities should not influence the pricing of
assets even though these regnlations may limit the
powers of many intermediaries. Similarly, acconnting
conventions that dictate the way intermediaries report
either their income or the values of their assets and
liabilities should not impede the efficient pricing of
assets. These regulations and conventions alter neither
investors’ perception of the returns and risks offered
by assets nor their ability to realize these returns and
risks.
Ou the other hand, taxes--inclnding income
taxes, sterile reserve requirements, the cost of regulation, and improperly priced liability insurance--affect
the pricing of assets by altering their net returns. Taxes
reduce the efficiency of financial markets, and this, if
anything, undermines the safety and SOUlldness of
savers’ investments. Unless the burdens of intermediaries’ taxes are offset by other considerations, these
liabilities discourage traditional financial intermediation by prodding banks, life insurance colnpanies, and
other intermediaries to recast their liabilities as "mntual funds" that also offer certain financial services.
If investors assess the prospective returns on each
asset differently, the prices of assets and the volume
of investment depend on the policies that govern the
activities of financial intermediaries. When not all
investors are informed equally well, intermediaries
can profit from their proprietary knowledge by raising
money from wary savers to invest in deserving assets,
thereby promising savers greater returns, other things
eqnal, while reducing the cost of capital for investment projects. The ability of intermediaries to "arbitrage" financial markets in this manner ultimately
rests on savers’ confidence in their expertise. Because
intermediaries’ cost of funds rises and falls with this
state of confidence, both the level and the volatility of
60
November/December 1995
the cost of capital for investment projects depends on
tile perceived safety and soundness of financial interlnediaries.
The lack of uniform information creates three
problems: (1) the cost of funds for financial intermediaries might be too high, on average, for the risks
inherent in their balance sheets; (2) the cost of funds
also might be too volatile; and (3) policies that set risk
premiums on behalf of outsiders might entail a cost of
funds that is, on average, too low, thereby encouraging intermediaries to assume too much risk. Public
policy has attempted to cope with these problems
through regulation and liability insurance.
Efficiency might be promoted best when supervisors audit the risks assumed by intermediaries, taking
into account as completely as possible their proprietary information, in order to levy reasonable preminms for insnring some of their liabilities, lnsnrance is
most appropriate for basic liabilities that are backed
to a substantial degree by assets that either are not
familiar in public markets or can become illiquid-certain bank accounts, insurance policies, and pension
plans. The enforcement of capital reqnirements alone
does not necessarily promote efficiency by controlling
the risks of intermediaries, because ratios of capital to
assets describe neither the risks assumed by intermediaries nor their capacity for protecting creditors from
losses. More revealing descriptions are provided by
analyses that isolate those economic conditions that
threaten the solvency of an intermediary. Liability
insurance premitnns would vary with these exposures.2(’ This approach, in principle, would apply
equally well to intermediaries that hold substantial
portfolios of investments and to those that maintain
only a small portfolio of assets compared to their other
commitments and transactions. Intermediaries might
pay a portion of these premiums by carrying more
capital or by assuming hedges, but when these reme25 At first blush, guarantees of bank accounts and insurance
policies are backed by calls against the resotn’ces of the survb.,ors-banks precommit, to a degree, in the form of the FDIC insurance
fund, but eventually the survivors must restore the fund after it
sustains substantial losses. The survivors, in turn, may transfer
some of this burden to taxpayers (see footnote 4).
-~a If guarantors have no particular comparative advantage for
assessing the likelihood that these threatening events will occur,
their premiums should reflect the going price of hedging, for
example, against a twist of the yield curve. By enforcing this
universal hedging, intermediaries that successfully bet against a
twist of the yield curve will not confuse their reward with pure
profit. According to traditional theory, the rents of intermediaries
are grounded in their unique knowledge of investment opportunities and their "arbit.’aging" market imperfections rather than their
bets on economic events.
New England Economic Review
dies are excessively expensive, intermediaries retain
the option of purchasing coverage from their "insurer
of last resort." When guarantors inevitably experience
claims that exceed their reserves, they, in turn, must be
able to obtain temporary funding at reasonable rates
without raising questions about the safety and soundhess of the accounts that they insure.
Regulatory policy affects not only the returns on
intermediaries’ proprietary assets, but also the returns
on assets that commonly trade in public markets. To
the degree effective regulation promotes safer and
sounder intermediaries by reducing both the average
risk premium and the volatility of the risk premium
required of their liabilities, it also tends to reduce the
force of the credit cycle, thereby diminishing the
gravity of some factors of risk common to all assets.
Snch a reduction of systematic risk would entail lower
premiums for all assets.2~
This close relationship between regulatory policy
and the cost of funds in fiuancial markets runs parallel
to that of monetary policy. Indeed, monetary policy
and regulatory policy do not work independently of
each other. When central banks change the terms on
which they supply their liabilities, the resnlting
change iu the supply of and demaud for funds depends on the regulations governing the behavior of
financial intermediaries. For example, Marriner Eccles,
Governor and Chairman of the Federal Reserve during the 1930s, noted (Eccles 1951, pp. 266-67):
How can the Reserve System fulfill its responsibility of
helping to maintain economic stability when the control
of the nation’s banking system, through which it is
snpposed to work, is divided between state and federal
authorities, and among federal authorities? ... Or when
the power of federal authorities to conduct bank examinations and issue regulations is divided among the FDIC,
the Comptroller of the Currency, and the Federal Reserve
Board, each of which has a different interest to be served
by the examinations it conducts and the regtflations it
issues?
... Clearly, if the System is committed to a policy of
monetary ease in times of depression, then bank-examination policies should follow a similar commitment. Or
if the System is committed to a policy of credit stringency
in order to curb an imminent inflation, then bank-examination policy should be bronght in line with that same
intention. Neither action was possible, however, so long
as examinations were also devised by the FDIC and the
Comptroller, whose personnel were disposed to follow
the same policies regardless of prevailing economic conditions.
Eccles recommended, to little avail, that representatives of the FDIC, the Comptroller’s Office, and the
NIwembe~TDecember 1995
Federal Reserve agree to a joint bank-examination
policy. More recently, critics have challenged regulators of banks and insurance companies for adopting
standards that diminished the potency of monetary
policy during the last recovery.
Just as the efficacy of mouetary policy depends on
regulatory policy, so regulatory policy is couditioned
by monetary policy. For example, the variance of
inflation versus the variauce of capacity utilization in
the economy depends on the rules guiding the monetary authority’s supply of base money (Fuhrer 1994).
In turn, the volatility of returns on assets and the
liquidity of intermediaries’ proprietary assets depend
The rules that best promote the
safety and soundness of financial
intermediaries cannot be
established independently of the
design of monetary policy.
not only on the size but also on the relative magnitudes of each of these variances, which are distinct
elements of systematic risk (Ross 1976; Sharpe and
Alexander 1990, Chapter 9). Furthermore, to the degree monetary policy attempts to control interest rates,
the risks confronting intermediaries and their regulators would differ from those arising should policy
attempt to control the growth of the stock of money or
nominal gross domestic product, or those arising if
monetary policy should attempt to manage the cost of
capital or Tobin’s q. Monetary policy not only affects
the means, variances, and covariances for assets, it
also influences the degree to which the returns on
assets or the values of assets tend to revert to trends.
Consequently, the rules that best promote the safety
and soundness of financial intermediaries canuot be
established independently of the design of monetary
policy.
Both monetary authorities and regulators essentially are in the business of writing "deposit insurance"--managing the price of risk and stabiliziug
economic performance, so that the values of investments generally fulfill reasonable expectations (Tobin
Regulation, therefore, is a public good. As Albert Wojnilower
has observed, banks are unique for having to pay for their deposit
insurance.
New England Ecom~mic Review 61
1958, 1982). Both attempt to "insure" savers, investors,
and productive activity against the consequences of
economic "shocks." Because regulations affect the
price of risk in financial markets and because this
influence varies with economic conditions, the actions
of regulators, like those of the monetary authority,
should be sufficiently flexible to adjust with economic
conditions, in order to foster the prudent valuation of
assets and the efficient flow of funds from savers to
investors. Regulating the volume of intermediation by
enforcing fixed standards for capital that are proportional to intermediaries’ investlnents in assets designated as risky, for instauce, might undermine the
stability of financial markets. At times, excessive confidence might entail an insufficient price of risk,
thereby fostering speculative investment. When confidence subsequenfly subsides, the rising price of
risk, reinforced by risk-based capital requirements
grounded in market-value accounting, amplifies the
credit cycle and increases the odds of a crunch. In
these circumstances, regulatory and monetary policies
would stabilize financial markets best by managing
the price of risk so that it dampens cycles in economic
activity.
Appendix
Figure 2
An intermediary finances a portion of its assets, A0, by
issuing debt, Lo. When the debt matures in t periods, the
intermediary will owe its creditors Lt = L0eft. At that time,
the capital of the intermediary will equal At Lt. (r is the
safe rate of interest. The following discussion explains the
pricing of the risk premium.) Figure A1 shows the probabilit3, distribution for the value of assets t periods in the future.
Taking into account the full range of values that are possible
for At, the expected value of assets is A~, and the expected
value of capital is A~ - Lt. If shareholders’ liability to
creditors were not limited, the expected value of their equity
would equal that of capital.
Because shareholders’ liability is limited, the expected
value of their equity is calculated only over the rauge of
values for At that exceed Lt; if At is lower than Lt, the value
of equity is zero. The value of equity in this case equals the
expected value of capital for the full range of A~ (as in the
first case) plus the expected value of Lt At when capital is
negative (the shaded region in the figure). Therefore, the
value of the intermediary’s eqnity in this second case equals
the sum of its capital and a put option with an "exercise
price" of L, and payoff equal to max(0, Lt - At) at the
"exercise date" t periods hence. (This combinatiou of an
equity stake and a put option is equivalent to a call optiou-the line in Figure lb is the intrinsic value of a call.)
The value of this put option for shareholders is the
62
November/December 1995
Figure
Probability Distribution for
Value of Assets
L~
A*~ = C~ + Lt
expected value of L~ - At when At is less than Lt. This
expected value increases as Ao - Lo beco~nes smaller or as
the variance of A iucreases; in both cases, the area of the tail
of the probability distribution to the left of Lt becomes
larger. If the distributiou of A is normal, the variance of A
per period is o2, and N[d] is the probability that a standard
normal variable does not exceed d, then the value of this put
option is (Sharpe and Alexander 1990, Chapter 18):
Put = Lo"N[-d2] - Ao* N[-d~], where
d~=
ln(Ao/Lo) + (r + .5o-2)t
The value of equity in pauel a is the sum of capital and the
value of this option. Because creditors assess the returns
on assets the sa~ne as shareholders, the value of creditors’
expected losses in panel b equals the value of the put optiou
derived above. Panel c shows the difference between the
value of equity and the value of the option, which equals
capital.
Figure 6
Iuformed iuvestors believe the standard deviation of
returns for the portfolio is cri, and they require a rate of
return of r~ for financing these assets. Uuinformed investors
believe the standard deviation is greater, oL.
If informed investors held both the equity and the debt
of the intermediary, the cost of funds wonld be r~, regardNew England Economic Review
less of leverage, 1, the ratio of the intermediary’s debt to its
assets. In this case, the value of the put option entailed by
leverage, p(llo-i), is the same for both shareholders and
creditors (see discussion of Figure 2). When the intermediary issues debt to uninformed investors, the value of the pnt
ol:;tion for creditors, p(llo-~.), exceeds that for shareholders.
The premium required by creditors rises relafive to that
required by informed investors as leverage increases. Accordingly, the intermediary’s cost of funds rises with leverage: r(/) = ri + [p(lla,) - p(ll~ri)].
Figure 7
The average cost of funds is that derived in Figure 6.
The marginal cost of ftmds equals:
d(Ir(1))
dl - r(I) + h"(I).
of 2 dollars of risky assets for every 3 dollars of safe assets;
otherwise, A’ is zero:
A, = maxl[10C, ~ - (V~ , + t"; ~)], O)
A[ max([4C~ - V’e_,(l + r,)], O)
When the intermediary’s capital falls below 0.5 percent,
it "fails," and its capital is restored to 10 percent. In the
simtflation shown in the graph, the intermediary fails 11
times, its mean capital-asset ratio is 9.5 percent, and the
annual standard deviation of this ratio is 3.5 percent.
Panel b: The assumptions are the same as those for the
previous panel, except that the intermediary sells risky
assets in order to maintain only 4 dollars of risky assets per
dollar of capital when this ratio exceeds 4:
&; - 4C~ = V;_~(I + r~).
Panel a: An iutermediary holds risky and safe assets, financed by equity and "deposits." The expected return on
risky assets, E(q), is 10 percent annually; the standard
deviation of this return, std(et), is 6 percent annually; and the
correlafion coefficient between ammal returns (a first-order
Markov process) is 60 percent:
rt = .10 + ~t
In the simulation shown in the graph, the intermediary fails
4 times, its mean capital-asset ratio is 9.1 percent, and the
ammal standard deviation of this ratio is 3.5 percent.
Panel c: The assumptions are the same as those for the first
panel, except that the valne of risk), assets tends to revert to
a trend:
trend~ = V~(1.1)~
r~ = .10 + ,
~/~ ~ N(0, .06~(1 .6x)).
The return on the intermediary’s safe assets and the
l’etum that the intermediary pays on its deposits is 7 percent.
The values of risky and safe assets increase according to
their returns and any new investlnents in these assets, A~
and A~; likewise, the value of its deposits increases as a result
of crediting interest and new inflows, A:
v; = vL,(t + ,’,) + a;
1.1~ = V[ ~(1.07) + A~
LI- L~_dl.07) + A~.
The capital of the intermediary, C, is the difference
between the value of its assets aud the value of its deposits,
L. When its capital per dollar of assets the previous year
exceeds its target of 10 percent, the intermediary issues new
deposits; otherwise, A is zero. If the intermediary’s risky
assets are less than 4 times its capital, the intermediary
purchases more risky assets in order to maintain the ratio
November/December 1995
~ = .6~ ~ - 2 logIV~ ~ - trend~ ~) +
~1~ ~ N(0, .05-’(1 - .6~-))
V;-= V; ~(1 + r,).
The standard deviation of annual rettn’ns behind the
simulation shown in the graph is 7.5 percent. Yet, because of
the tendency of the value of risky assets to revert to trend,
the intermediary does not fail during this simulation, its
mean capital-asset ratio is 10.3 percent, and the annual
standard deviation of this ratio is 2.2 percent.
Panel d: The assumptions are the same as those for the
previous panel, except that the intermediary sells risky
assets in order to maintain only 4 dollars of risky assets per
dollar of capital when this ratio exceeds 4, and this sale
entails transactions costs equal to 10 percent of the value of
the risky assets that are sold.
In this simulatiou, the intermediary fails 5 times, its
mean capital-asset ratio is 9.1 percent, and the annual
standard deviation of this ratio is 3.6 percent.
New England Economic Review 63
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